All the Devils Are Here [156]
There was another component to the thinking, too. The leverage in the system had built up slowly. “It was a gradual process that got us to where we were,” says a former Treasury official. “So you’d think it would be a gradual process that got us out.”
In this assumption, however, they could not have been more wrong.
17
“I’m Short Your House”
Scene I: Summer 2006. Seemingly out of nowhere, New Century Financial, the country’s second largest subprime-only originator, has a pressing need for cash. Having made $51.6 billion worth of subprime loans in 2005, it is discovering that too many of its loans are going sour way too fast. Particularly troubling: early payment defaults are spiking. Those are loans where the borrowers are in default practically from the moment they agree to the loan. Early payment defaults can often trigger repurchase requests from investors, requiring the lender to buy them back. That is happening to New Century. In 2004, it repurchased $136.7 million worth of bad loans. In 2005, that number rose to $332.1 million. By June of 2006, it has been forced to repurchase an additional $315.7 million in defaulted loans.
Worse, one of New Century’s tried-and-true techniques for recirculating its repurchased loans is no longer working. In previous years, after buying defaulted mortgages out of securitizations, it would simply stick them into a new sale, according to one close observer. This worked because New Century’s loan volume was growing so rapidly that the bad mortgages could be buried as a small part of a big new sale. But by 2006, volume is starting to slow. New Century’s perpetual motion machine is grinding to a halt.
Meanwhile, New Century is running low on cash. On August 17, CFO Patti Dodge sends an e-mail to Brad Morrice, the CEO: “We started the quarter with $400mm in liquidity and we are down to less than $50mm today,” she writes. In explaining the problem to the company’s board, Morrice cites “continued difficult secondary market conditions leading to warehouse line margin calls, higher investors kick outs [meaning that wary investors are refusing to purchase loans] and loan repurchases.” Internally, top management begins receiving a weekly report monitoring its problems. It is entitled “Storm Watch.”
Does Wall Street know about New Century’s problems? Of course it does! One Wall Street banker tells New Century that its problems aren’t all that unusual, according to a report done later by a bankruptcy examiner. There are, the examiner will write, “dramatic industry-wide increases in early payment defaults and lower origination volumes.”
Amazingly, Wall Street is still willing to extend a lifeline to New Century: the company raises $142.5 million in the second half of 2006. Yet investors are largely left in the dark. New Century doesn’t disclose either the big increase in early payment defaults or the staggering $545 million backlog of repurchase claims—i.e., claims that the company has received but hasn’t yet paid. Instead, New Century tells investors that it believes that repurchase requests “will stabilize, then decline.”14
Scene 2: Fall 2006. Larry Litton is a mortgage servicer. In 1988, he and his father, Larry Litton Sr., founded Litton Loan Servicing, building it into one of the nation’s largest mortgage servicers. Inevitably, they service a lot of mortgages for subprime originators, including Bill Dallas’s Ownit and WMC, which was founded by Amy Brandt and which GE Capital bought in 2004. The two combined are cranking out more than $40 billion worth of loans a year.
Litton also notices that early payment defaults are soaring. The mortgage originators are freaking out and blaming him. “The WMC guys are saying, ‘You suck,’” Litton recalls. He remembers thinking, “Maybe we’re doing something wrong.” So Litton comes up with what he calls an “ultra-aggressive